Calculate how much the team thought it was saving

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Financial Economics

Assignment 1 - Bonds

Question 1. Go to the U.S. Treasury website here and look up the daily yield curve rates. Note that the rates are reported as percentages, so 0.35 should be read as 0.35% or r = 0.0035.

(a) Report the yields for the one, two, and three-year Treasury notes. Is the yield curve upward or downward sloping? According to the expectations theory, what does this say about investors' beliefs regarding short term interest rates?

(b) Although we cannot know what future bond yields will be, we can look back in time and check whether investors' past beliefs were confirmed. Report the historical yields for the same Treasury notes from dates one, two, and three years ago. Do the expectations indicated by the historical yield curves line up with the actual movement of interest rates?

(c) For each of the previous years, use the one and two-year spot rates to calculate the one-year forward rate one year from that date and check how it compares to the actual one-year spot rate from the following year.

Question 2. During the 2000 Major League Baseball season, Bobby Bonilla was no longer playing for the New York Mets but was still owed his $5.9 million salary. The team was seeking to free up the money in order to sign more players in anticipation of making a run at the World Series, and Bonilla's agent offered the team a deal where he would defer payment for 10 years, and then be paid an annuity for the next 25 years at an interest rate of 8%. That is every July 1st from 2011 to 2035, Bonilla would receive a check from the Mets that often exceeded the salaries of some of the team's best young players, a date now commemorated by bitter Mets fans as "Bobby Bonilla Day."

(a) Using the agreed upon interest rate of r = 0.08, compute Bonilla's annual payoff. How much money will he receive overall?

(b) Unbeknownst to many at the time, the reason that the Mets were eager to make this deal was that their owner was heavily invested with Bernie Madoff, who was guaranteeing annual returns of 12% to 15%. Of course, this was revealed to be a Ponzi scheme in 2008, before Bonilla's payments had even started. Using a low-end estimate of r = 0.12, calculate how much the team thought it was saving by making this deal.

(c) As a result of the global financial crisis of which the Madoff scandal was only a part, interest rates were historically low for nearly a decade afterwards. Using a more realistic discount rate of r = 0.04, calculate how much Bonilla gained as a result of this deal.

Question 3. Suppose that we have one, two, three, and four-year bonds, each with face value normalized to $1000 and an annual coupon with a rate of 8%, priced as follows.

Bond	1 Year	2 Year	3 Year	4 Year
C₁	1080	80	80	80
C₂		1080	80	80
C₃			1080	80
C₄				1080
Price	1008.00	1005.89	993.10	969.12

Using the law of one price, calculate the one, two, three, and four-year spot rates.

Reference no: EM133388508

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